Pollution credits convert the atmosphere from a commons into private property. They can reduce pollution if the pollution cap is lower than the unrestricted total and lower the costs of reducing pollution if credits can be sold from low-cost avoiders and high-cost avoiders.

We are all aware that everybody's business is nobody's business. When nobody owns the right to a scarce resource, the resource tends to be over-exploited. For example, air is polluted because nobody owns it. So the atmosphere becomes an open sewer for air polluters. There is no incentive for anybody to restrict his own contribution to atmospheric pollution since the costs of reducing pollution must be privately borne but the benefits of cleaner air is diffused over the whole community.

Suppose individuals are instead assigned free quotas to pollute1 that are less than his unrestricted amount and the actual amount of individual pollution can be inexpensively monitored. In addition, individuals are allowed to sell their rights (or generally use quotas) to pollute if they cannot use up their own pollution quotas. Thus, under private ownership of pollution rights, an individual must now weigh the opportunity costs of using up his rights instead of selling his rights to someone else who needs to pollute more than his own share. It makes sense for an individual who has higher cost of reducing pollution through other means to buy more pollution rights, and for an individual who has lower cost of reducing pollution through other means to sell his pollution rights. In equilibrium, the overall cap on air pollution can be achieved at the lowest possible costs (see Guilt-free Pollution).

Something very similar to this idea is in fact being carried out in the United States. In the Clear Air Act Amendment of 1990, Congress let the Environmental Protection Agency assign pollution allowances to 445 of the biggest U.S. power plants and factories based on past fuel consumption. Under this credit program, pollution allowances have become property privately owned by these companies, which they are allowed to trade freely.

Allowance trading has been quickly adopted and will continue to grow because it has achieved pollution reduction at the lowest cost possible. Before this program was established, energy companies that produced pollution exceeding the limit had to either buy state-of-the-art equipment to cut the emissions or stop production. Now, they can buy pollution credits from other companies that meet the limits with room to spare. The companies that are selling pollution credits often use the profits to buy less-polluting equipment. The national pollution cap is being lowered annually and is applied to more power generating units. As a result, the national emissions total has been lowered drastically.

All is not well, however. Overall reduction of pollution without regional caps can still lead to "hot spots" that buy pollution credits from utilities far away to maintain their own pollution. Applying the same concepts to other greenhouse gases other than just sulfur dioxide and nitrogen oxide, to other countries, and to other sectors other than power generation presents formidable monitoring challenges. Besides, how should the country pollution quotas be assigned? Using historical levels of pollution as bases would enshrine the high per capita pollution levels of rich countries and freeze the low per capita pollution levels of poor countries. Allowing higher than current per capita pollution quotas to poor countries may encourage polluters in rich countries to simply buy the unused quotas at little costs to avoid the higher costs of reducing pollution (see also Fished Out!).

Note:

Even though quotas are given out for free, the imposition of an overall pollution limit is essentially a disguised tax on pollution. But unlike an overt tax, pollution limit does not generate any tax revenue to the government.

Even though quotas are given out for free, the imposition of an overall pollution limit is essentially a disguised tax on pollution. But unlike an overt tax, pollution limit does not generate any tax revenue to the government.